Capital Structure

Decisions
S ANA TAUSEEF
Outline
What is optimal capital structure?
Components of risk and return
Measures of business and financial risk
Capital structure theories

2
Optimal Capital Structure
Capital structure is the mix of debt and equity which the company uses to
finance its assets

Optimal Capital structure is that composition of debt and equity which:

◦ Minimizes the WACC
◦ Maximizes the value of firm

3
Components of Risk and Return
Total uncertainty of the • Business Risk
firm’s profits/returns can
be broken down into: • Financial Risk

Firm’s cost of equity can • Required return on overall assets

be broken down into: • Financial risk premium

4
Business and Financial Risk
Business risk is the uncertainty in future EBIT,
NOPAT, or ROA

Financial risk is the additional uncertainty in EPS

and ROCE because of the firm’s use of debt or
preferred equity

5
Measures of Business Risk
•Operational Breakeven: Level of sales at which EBIT is equal to zero
•Degree of Operating Leverage: Percentage change in EBIT resulting
from a percentage change in sales
•Expected variability in ROA (standard deviation)

6
Example 1: Interpreting the Operating
Breakeven Level and DOL

Firm X Firm Y
SP/ unit 5 5
VC/ unit 2.5 1
TFC 100,000 250,000
Current Sales (units) 100,000 100,000

Operating BE (units) 40,000 62,500

Operating BE ($) 200,000 312,500

7
Measures of Financial Risk
•Financial Breakeven: Level of EBIT which is sufficient enough to cover
financial costs
•Degree of Financial Leverage: Percentage change in NI available to
CSH resulting from a percentage change in EBIT
•Expected variability in ROCE (standard deviation)

8
Example 2: Financial Break-even
Point
In order to have a zero EPS, the operating income should fully cover the
interest and the pre-tax preferred dividends.

For Firm X:
Interest $25
Preferred Dividends 37.5
Tax rate 50%

Financial Breakeven $100,000

9
Example 3: Lets calculate the business and financial risk for the
current and proposed capital structures if the possible EBIT values
are PKR500,000; PKR1000,000 and PKR1500,000
Current Capital Structure Proposed Capital Structure

Assets PKR8,000,000 PKR8,000,000

Debt PKR0 PKR4,000,000
Equity PKR8,000,000 PKR4,000,000
D/E ratio 0 1
Share Price PKR20 PKR20
Number of shares 400,000 200,000
Interest rate 10% 10%
Tax rate 20% 20%

10
Business and Financial Risk
EBIT 500,000 1,000,000 1,500,000
Current Capital Structure
Net Income 400,000 800,000 1,200,000
ROA (NOPAT/Assets) .05 0.10 0.15
ROE (NI/Equity) .05 0.10 0.15
Proposed Capital Structure
Net Income 80,000 480,000 880,000
ROA (NOPAT/Assets) .05 0.10 0.15
ROE (NI/Equity) 0.02 0.12 0.22

Volatility of ROA: 4.1 percent; volatility of ROE (proposed CS): 8.1 percent

11
 Mod and Miller (MM) Theory
Capital MM Theory with Taxes
Structure Trade-off Theory
Theories Signaling Theory
Pecking Order Theory

12
Basic MM Theory Assumptions
Perfect Capital Markets
◦ No taxes
◦ No transaction costs
Efficient markets
◦ All investors have same expectations about the firm’s future EBIT
Single rate for borrowing and lending
Borrowing/lending is completely risk-free
Individuals can borrow or lend at the same rate at which companies
borrow or lend.
Firms follow 100% payout policy

13
Basic MM Theory
Following these assumptions means we ignore
important impacts of debt financing
No tax benefits from interest payments.
No chances of the company going into financial
distress or bankruptcy.

14
MM Proposition 1: No magic in
leverage
Under the perfect and efficient market conditions, value of the firm
doesn’t change as the capital structure changes.

Capital structure is thus irrelevant.

Firm’s WACC is the same no matter what the mixture of debt and
equity is used to finance the assets.

Firms are classified into different business risk classes. All firms within
one particular risk class have same COC regardless of their use of debt.

15
Home-made versus
Corporate Leverage
◦ When there are no taxes, and capital markets function
perfectly and efficiently, it makes no difference whether the
firm borrows or individual shareholders borrow. Therefore,
the market value of a company does not depend on its capital
structure

◦ Under MM Basic Theory, debt Policy doesn’t Matter because

home-made leverage is a perfect substitute for corporate
leverage

◦ Because of the option of home-made leverage, an investor

would be indifferent between the company’s financing
choices

16
Example 4: Home-made
leverage as substitute of
corporate leverage
Current Capital Proposed Capital
Structure Structure
Assets PKR8,000,000 PKR8,000,000
Debt PKR0 PKR4,000,000
Equity PKR8,000,000 PKR4,000,000
D/E ratio 0 1
Share Price PKR20 PKR20
Number of shares 400,000 200,000
Interest rate 10% 10%
Tax rate 0% 0%
Possible values of EBIT are PKR500,000; PKR1,000,000 and PKR1,500,000

17
Mr. A holds 100 shares of the company (for the figures shown in the
previous slide). Assume that the company wants to continue its all-equity
structure, but Mr. A wants the expected income under the proposed
structure. Let’s show how he can leverage his holding to get his desired
outcome.
EBIT 500,000 1,000,000 1,500,000
Current Capital Structure
EPS 1.25 2.50 3.75
CF for Mr. A 125 250 375
Proposed Capital Structure
EPS 0.50 3.00 5.50
CF for Mr. A 50 300 550
Home-made Leverage (Company continues all-equity, investor prefers new structure)
CF for 200 shares 250 500 750
Interest payment (200) (200) (200)
Net cash flow for Mr. A 50 300 550

18
Now assume that the firm decides to switch to the proposed
structure, but Mr. A wants a less risky outcome than expected
under the current structure. Let’s show how he could unlever
his position.
EBIT 500,000 1,000,000 1,500,000
Current Capital Structure
EPS 1.25 2.50 3.75
CF for Mr. A 125 250 375
Proposed Capital Structure
EPS 0.50 3.00 5.50
CF for Mr. A 50 300 550
Home-made Leverage (Company moves to new structure, investor prefers all-equity structure)
CF for 50 shares 25 150 275
Interest receipt 100 100 100
Net cash flow for Mr. A 125 250 375

19
Cost of Equity under
MM Basic Theory
Cost of equity can be calculated as:
KE = WACC + (WACC - KD) × (D/E)

Cost of equity rises as the firm increases its use

of debt financing.
Cost of equity has two components: return for
business risk and premium for financial risk.

20
Practice Question 1
Assume a firm operates in an MM’s ideal world. The expected NOI for
the firm is $1000 and COC is 15%. If the firm is an all-equity and a
zero-growth firm, what is the value of the firm? Value of equity? Cost of
equity?

Consider the information in the previous part, what will be the value of
the firm if the firm has a $1000 perpetual debt (at 10% interest rate)?
What is the value of equity? Cost of equity?

21
Explanation of MM Theory… in
their own words
“In an economist’s ideal world, the total market value of all the securities issued by a
firm would be governed by the earning power and risk of its underlying real assets and
would be independent of how the mix of securities issued to finance it was divided
between debt instruments and equity capital.

Some corporate treasurers might well think that they could enhance total value by
increasing the proportion of debt instruments because yield on debt instruments, given
their low risk, are, by and large, substantially below those on equity capital. But under
the ideal conditions assumed, the added risk to the shareholders from issuing more debt
will raise required yields on the equity by just enough to offset the seeming gain from
use of low-cost debt.”
MM Theory with Taxes
We are now considering the advantage of debt financing in the
form of interest tax savings.
But we are still ignoring the disadvantage of debt financing
since we are still ignoring the chances of bankruptcy and
financial distress.

23
MM Theory with Taxes
Value of the firm levered (VL) is equal to the value of the firm
unlevered (VU) plus the present value of the interest tax savings:
VL = VU + T × D
Debt financing is highly advantageous and, in the extreme, a firm’s
optimal capital structure is 100% debt.
A firm’s WACC decreases as the firm increase its debt financing.

24
Cost of Equity under MM with
Taxes
Cost of equity can be calculated as:
KE = WACCU + (WACCU - KD) × (D/E) × (1-T)

Cost of equity rises as the firm increases its use of debt financing but by a
lesser magnitude because of tax advantage.
Cost of equity has two components: return for business risk and premium for
financial risk.

25
Practice Question 2
Consider two firms U and L identical in all aspects except the financing mix.
Firm U is an all-equity firm and L has a perpetual debt of $1000 (at interest
rate of 8%). Both firms are zero-growth firms with an expected NOI of $1000.
Firm U has a COC of 10%. Tax rate is 30% for both U and L. What is the value
of firm, value of equity and cost of equity for firm U? What is the value of firm,
value of equity, cost of equity and COC for firm L?

26
Practice Question 3
Molly Corp. has no debt but can borrow at 9%. The firm’s WACC is currently 15% and the tax
rate is 35%.
What is Molly’s cost of equity capital?
If the firm converts to 25% debt, what will it’s cost of equity be?
If the firm converts to 50% debt, what will it’s cost of equity be?
What is Molly’s WACC is parts b and C

27
Trade-off Theory
Now we introduce the risk (bankruptcy and financial distress) in the
MM’s world with corporate taxes
We are now considering the advantage of debt financing in the form of
interest tax savings.
We are also considering the disadvantage of debt financing. The
higher the proportion of debt in firm’s capital structure, higher is the
chance of company going into financial distress and bankruptcy.

28
Trade-off Theory
According to the tradeoff theory, a firm’s optimal capital structure is
found by trading off the tax benefits of debt against bankruptcy costs

Value of the firm levered (VL) is equal to the value of the firm
unlevered (VU) plus the present value of the interest tax savings less
the present value of expected financial distress/bankruptcy costs:
VL = VU + T×D - PV of FD/B Costs

29
Trade-off Theory
An optimal capital structure exists that balances the costs and benefits
resulting from the use of debt
◦ At low leverage levels, tax benefits outweigh bankruptcy costs.
◦ At high levels, bankruptcy costs outweigh tax benefits.
◦ Optimal capital structure is between 0 and 100% debt financing.

30
The optimal debt-to- 0.4

asset ratio for Pakistan’s 0.35

textile firms is estimated

Predicted Return on Equity (ROE)

as 56 percent 0.3

0.25

The results are based on 0.2

the panel data of 95

0.15
textile firms for six years
from 2002-03 to 2007- 0.1

08. 0.05

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Tauseef, S., H.D. Lohano and S.A. Khan. (2012).
Effect of Debt Financing on Corporate
Financial Performance: Evidence from Textile Debt-to-Asset Ratio (DA)
Firms in Pakistan. Pakistan Business Review.

31
Practice Question 4
The Boisjoly Company currently has no debt. An in-house research group has just been assigned to determine
whether the firm should change its capital structure. Mr. Harris, the in-house analyst, who is well versed in
modern finance theory, has decided to conduct the analysis using the extended MM framework. The following
data are relevant to the analysis:
EBIT = $4 million per year, in perpetuity
Federal-plus-state tax rate = 40%
Dividend payout ratio = 100%
Current required rate of return on equity = 12%
Mr. Harris estimated the present value of financial distress costs at $8 million. Additionally, he estimated the
following probabilities of bankruptcies: At a debt level of (Millions of Dollars)
$0 $2 $4 $6 $8 $10 $12 $14
Probability of financial distress 0 0 0.05 0.07 0.10 0.17 0.47 0.90

What level of debt would Mr. Harris recommend as optimal?

32
Practice Question 5
The Boisjoly Company currently has no debt. An in-house research group has just been assigned to
determine whether the firm should change its capital structure. Because of the importance of the decision,
management has also hired the investment banking firm of Stanley Morgan & Company to conduct a
parallel analysis of the situation. The following data are relevant to the analysis:
EBIT = $4 million per year, in perpetuity
Federal-plus-state tax rate = 40%
Dividend payout ratio = 100%
Current required rate of return on equity = 12%
The cost of capital schedule predicted by Ms. Broske follows: At a debt level of (Millions of Dollars)
$0 $2 $4 $6 $8 $10 $12 $14
Interest rate (%) - 8.0 8.3 9.0 10.0 11.0 13.0 16.0
Cost of Equity (%) 12.0 12.25 12.75 13.0 13.15 13.4 14.65 17.0

What level of debt would Ms. Broske recommend as optimal?

33
Signaling Model
MM assumed that investors and managers have access to the same information. Now
we introduce information asymmetry in a risky world with corporate taxes
But, managers often have better information. Thus, they would:
◦ Sell stock if stock is overvalued.
◦ Sell bonds if stock is undervalued.
New stock sales is taken as a negative signal by investors.

34
Pecking Order Theory
Signaling theory recognizes that there is a preferred “pecking
order” of financing
Firms prefer to use internal equity (retained earnings) to finance new
investments. If there is an inadequate amount of retained earnings
then debt financing will be used. New common equity is used as a
last resort only
Firms try to keep the equity ratio up and debt ratio down so as to
maintain maximum financial flexibility (reserve borrowing capacity)

35
Readings
Brigham e. F. & Ehrhardt, M. C (2020). Financial Management: Theory & Practice.

Corporate Finance. CFA-II Program Curriculum.

36